I’ll come right out and say it: I don’t think the student loan tax bomb is going to happen. The borrowers who earn forgiveness on an IDR plan probably won’t face the much-feared tax bill.
Obviously, I’m not 100% certain about this prediction, but things are definitely trending in the right direction for borrowers.
I’m putting my track record of accurate student loan predictions on the line and saying that the tax bomb won’t become a reality.
Why a Huge Student Loan Tax Bill is Unlikely for ICR, IBR, PAYE, and REPAYE Borrowers
Inside the recently passed Covid-19 relief package is a provision that eliminates the tax on forgiven student debt until 2026. For the borrowers who will earn Income-Driven Forgiveness in the next few years, there is nothing to predict — there will be no tax bomb.
Unfortuantely, most borrowers currently on the IDR plans will not qualify for forgiveness by the December 31st, 2025, expiration. One noteworthy aspect of the recently passed provision is that it eliminates the tax from the first borrowers earning forgiveness. To date, 32 borrowers have had their loans forgiven under an IDR plan, and that number should grow considerably in the coming years. Congress is actually addressing this issue before it becomes a widespread problem that impacts large numbers of Americans.
Additionally, this isn’t the first time Congress eliminated a tax on student loan forgiveness or cancellation. A couple of years ago, Congress removed the harsh tax on student loans forgiven due to death or disability discharge. Like the recent legislation, the provision ends December 31st, 2025.
The message from Congress is clear: student loan borrowers who have their debt discharged should not pay tax on the forgiveness.
Supporting the Student Loan Tax Bomb Would Be Dumb Politically
Stepping back from what the rules should be or what is fair, let’s look at the politics.
Calling for a huge tax bill for someone who spent at least 20 years making student loan payments looks bad. Democrats have strongly advocated for student loan cancellation and further help for borrowers. Republicans have built their brand on tax opposition.
When this issue comes up for debate again, eliminating the tax should get bipartisan support. Democrats need to stick up for student loan borrowers to get elected. Republicans need to oppose tax increases to get elected. Preventing a tax increase on student loan borrowers should be an easy sale.
Even though there is a huge debate about student loan cancellation, there hasn’t been a debate on these tax issues. Most advocates and experts argue that the tax bomb is a bad policy, and there has been little opposition.
Taxing Forgiveness is Bad Policy in this Case
The general rule of the IRS on taxing forgiven debt makes sense. Suppose my employer loans me $1,000. When you borrow money, there is no tax paid by the lender or the borrower. Instead of giving me a raise or a bonus, my employer cancels my debt. You can see how easy it would be to use a strategy like this to avoid taxes if there wasn’t a rule taxing canceled debt.
Applying this rule to student loan forgiveness and cancellation doesn’t make sense. If I qualify for IDR forgiveness, it is because I’ve been on an income-driven repayment plan for 20 years. I’ve made 20 years’ worth of payments, and I’ve paid interest on the debt. Presumably, I’ve been on this plan because I can’t afford to pay off my student loans under the standard 10-year plan. In this situation, student debt has been a financial hardship, and I’ve gone to great lengths to do what I can to make payments.
A huge tax bill in that situation is wrong. For starters, many borrowers who face the tax bomb probably can’t afford the bill. Secondly, it isn’t forgiving the debt if you are just turning it into an IRS bill.
My Big Hesitation in Predicting the Elimination of the Student Loan Tax Bomb
For years, when I discussed student loan issues, I only made suggestions based upon the current status of the law. This approach was safe and it was easier.
However, my inbox was full of emails from readers asking about what might happen and how to plan for various possibilities. It is smart to plan for various contingencies, and to the extent I can offer insight on a topic, I try to do so.
In the case of the student loan tax bomb, I still think borrowers should prepare as though it will happen. As a student loan borrower myself, I’m making preparations for a huge tax bill. My plan incorporates the fact that I think I probably won’t face this bill. Even though I don’t expect the tax to happen, I’m not going to bet on Congress doing the right thing or the smart thing. I have a backup plan in place, and I think every borrower should do the same.
Please don’t assume Congress won’t tax forgiveness. Get ready for a tax bill, and when Congress eliminates the tax, enjoy the fruits of your labor.